Whistleblower Explains One Way Cloud Companies Can Cook Their Books

Cloud computing is clearly changing the way the industry buys software, but it could also be tempting some SaaS companies to dupe investors.The poster child for the situation could be SucessFactors, a cloud-based app company bought by SAP in February. The company was accused of misleading accounting procedures last year by a whistleblower who reported his misgivings to authorities, Francine McKenna of Forbes writes.

This wasn’t the first time the red flag was raised over SuccessFactors’s accounting. ZDNet’s Dennis Howlett had also documented weirdness in how SuccessFactors reported revenue to investors via SEC filings.

Business Insider talked to the whistleblower, a salesperson who joined SuccessFactors from one of the company’s acquisitions. He said that, from 2009 to 2011, SuccessFactors salespeople were improperly writing contracts to make the company look like it was growing faster than it was.

The issue stems from how software-as-a-service [SaaS] companies book revenue. When a SaaS company signs a new customer, that customer typically signs on for a multi-year deal, typically three years. But GAAP accounting rules only allow the company to recognise the revenue after the service is performed, McKenna reports.

Cloud companies want to show investors that, for every new customer they sign, they get far more money guaranteed under the length of the contract. That is often reported as a non-GAAP “backlog” figure.

This former salesperson told Business Insider that SuccessFactor’s accounting controls were so lax that salespeople were rewriting existing multi-year subscriptions as new contracts each year. This let salespeople get a commission on a new contract, even though the client was not a new customer. It also meant that when SuccessFactors filed documents to the SEC, it was reporting big “backlogs” and a lot of new customers that it really didn’t have, he said.

“It was about salespeople manipulating the system to get extra commissions. I wasn’t thinking they were committing fraud at the time. It was like the parents are gone and kids are having a party,” the whistleblower said.

The first indication that something was wrong was in 2009, when SuccessFactors stopped reporting the “backlog” number. The SEC asked why it eliminated this number and SuccessFactors said that it didn’t think investors found the metric useful.

Meanwhile, in 2010 and 2011 the company made multiple acquisitions. “They had to scramble to acquire a bunch of companies to make it look like they weren’t going backwards from a customer standpoint,” our source said.

But in its 2011 annual report, filed in March after SAP announced its intent to buy SuccessFactors but before the deal closed, SuccessFactors backtracked and admitted that its accounting suffered from “a material weakness” and “that our internal control over financial reporting was not effective as of December 31, 2011.” The company at that time called out $2.9 million of misreported revenue.

When SAP bought SuccessFactors, SuccessFactors was predicted to have $502 million in revenue in 2013. SAP paid a premium, eight times SuccessFactors’ forecast revenue for the next year. That compares with a median of three times revenue other companies paid for the 32 North American software mergers that occurred over the past five years, Bloomberg reported at the time.

SAP said that it did conduct its own internal investigation about the missing backlog number. The investigation was “conducted by an independent firm,’ a spokesperson told us. “We provided the SEC with information about the matter but have had no further interaction.”

If the SEC is still looking into the situation, SAP says, “We’re not aware of an SEC investigation.”

Yesterday, SAP explained that with its quarterly financial reports, it would document revenues from another acquisition, Ariba, as a separate line item. It would report SuccessFactors revenues combined with SAP’s other homegrown cloud businesses, such as ByDesign.

SuccessFactors investors lucked out. SAP needed to jump start its cloud business and was willing to pay a premium to do it. But there’s still a lesson for investors here. They need to look carefully at revenues and customer numbers. If they rise, even though the workforce, backlog/bookings shrink, that should be a red flag.